Corporate Buy Backs and Market Ramifications

Corporate buy backs have contributed largely to the increased PE ratio we’ve seen for the last 8 or 9 years. But where do we go from here? Traders discuss the ramifications of corporate buy backs, and what long and short term investors should look out for.

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Corporate buy backs – long and short-term effects

Moderator :
Good afternoon SizeTraders, how is it going? Amos here with Gary, head trader, at SizeTrade. Gary, we spoke in the past of how every trader, whether it’d be long or short-term, should be paying attention to corporate buy backs and we had a lot of questions coming about it. So, I wanted to see if you could clarify some things for us.

First, why are buy backs so important for the market short-term? And, why do you think this is a negative thing for the markets long-term and a negative thing for the overall economy?

Gary:
Hey Amos! How is it going?

Yes, buy backs are something I’ve been talking about for years now. I was kind of against them when they first started out. I thought it was a big deal. Now, you see more of the mainstream media mention it. I still don’t think they talk about it as much as they should.

Moderator :
When you say, ‘’when they first came out’’, what are you talking about? How many years are we looking at?

Gary:
I didn’t mean when they first came out. When they first became on my bubble; when I first started noticing that corporations were increasing buy backs, and it was becoming an earnings driver of EPS for them as opposed to organic growth. They were becoming more inclined to do buy backs versus use capital for researching development or other organic take-overs even. They felt it was an easier use of money with low interest rate.

Moderator :
So how long has this trend been going for?

Gary:
After the crisis. Well, we saw buy backs right before the crisis reached highs.

Moderator :
You’re talking about 2008?

Gary:
Yes, 2007-2008. We saw them reach highs and then after the crisis, we saw slow down in buy back because it was hard to get cash. Then, when everything stabilized in 2010, this became one of the more preferred ways to get earnings per share growth for big corporations. When you really saw it pick up is when active investors started picking on companies with good balance sheets and that could go out there and raise capital. We are forcing the CEO and companies to use their balance sheet to lever up and do buy backs.

I started looking at it in 2010-2011 as a reason why the market could go higher and would continue to go higher; we’ll talk about that in a second. Now I’m talking about it more as of a worry for long term US GDP growth rate. I think that in the near term, as long as buy backs continue, it should make a nice floor for the overall market, but we’re getting to the end of it. We’re getting to a point where the balance sheets of company are too big. The amount of buy backs that they can do will probably slow down. Especially if interest rate spike a little bit more. We’re 2.5% on a 10 year and if it goes up to maybe 3-3.5%, buy backs will slow down. Also, balance sheets are getting so big that a lot of investors are starting to look twice at it and asking if the rating they have is a good rating, considering they have so much debt on their balance sheets.

So let’s go back to how I started. This is something that I took a look at right after the crisis; right after it started happening in 2010. It was one of the main reasons, I believe, that the stock market had legs to go higher. In 2010 or 2011, corporations became the biggest buyers of stocks out there. They grew more than any other group, just from the mass amount of buy back they were doing.

The reason why companies do buy backs is that when you retire shares (buy back shares), you’re outstanding share account goes down. Earnings per share are calculated by your total earning divided by total outstanding shares. So if you could grow your earnings, that’s great. Let’s take an example of a million shares outstanding and a company that earns a million dollars every quarter. So you would take a million dollars of earnings divided by a million shares and you would get earnings per share of a dollar per share. Then, you put some type of multiple on that company based on its growth rate, the industry it is in and overall economic conditions. Let’s use an average PE ratio, which is the multiple we use of 16 to 17 times. So this company that earns one dollar per quarter on a consistent basis over a year, which is four dollars a year, would be then multiplied by, let’s say, 15 and it would be trading at $60 a share. That would be the fair value of the company that analysts would consider. Now, if you can grow the earnings, that’s great. So, if you double your earnings and get it to two million dollars and still have one million shares outstanding, you’ve grown your earning per share from a dollar to two. So now instead of multiplying $4 times 15, which is the earnings for the year, you’re multiplying $8 earnings per year times 15. That makes it to a total of $120 per share. So by increasing your growth, the overall outstanding earnings, you’ve increased the share price by double.

That’s the preferred way that the stock market works. That’s the way that the market should work; as you grow your earnings, the value of your stock should get more expensive.

Now the other way to do it, which is what a lot of people call Financial Engineering, is by decreasing the outstanding shares. So you’d continue to earn a million dollars in total earnings, but instead of dividing it by a million share outstanding, you’re dividing it by half a million share because you were able to buy back half of your float. So now you’re earning $2 per share but you didn’t actually grow your earnings. So again, the stock goes up to $120 a share without any actual growth in the earnings. So the company didn’t actually do anything better. Now, this is really common; typically, it’s towards the end in bull market. In the beginning stages of a bull market, the company has grown since we’re coming out of a recession and earnings are growing organically. It’s in their interest to hire more workers, expand operations, and spend a little bit of money on research and development to get more products out there. That’s how a proper economy should work. Towards the end of the bull market, you’re going to start seeing a slow down and a place where companies start taking over other companies to increase earnings by taking competitors. But, also, they begin to buy back stock because it’s a very easy way to increase your earnings per share, which is what the stock market cares about and what investors care about. And, investors are the boss of the CEO at the end of the day.

Moderator :
Let me ask you something, Gary. If you’re saying that companies are able to artificially inflate their earnings per share, don’t investors see this? Don’t they see what’s going on? Isn’t this public information? Why do they still buy the stock? Why do they still buy these companies if they know they are artificially being pumped?

Gary:
Well in the beginning, for short-term, you get a big boost because if you’re earning $1 per share and you’ve cut the overall outstanding by half, you’ve increased your earnings per share to $2. Now, I’m not saying that it happens drastically; I’m just making a point here. They usually retire 10% of their stock and they do have some type of earnings growth, lackluster. So what ends up happening is that you get 10% earnings growth, 7% of it which was due to cutting back outstanding share and 3% was organic growth. This is good for shot-term traders and this why activists love this; it actually increased the evaluation of the company. It also creates demand. The stock market is a market place; we have buys and sellers, demand and supply. So for companies buying back in stock, and we’re talking about multi billion dollars buy back over few quarters, they’re now buying a huge portion of their average daily volume. They’re creating a floor for the stock sometimes, where they tell their bankers, for example, ‘’ I want to buy it any time it goes under $75 if the stock is trading at $76-$77.’’ So they create a floor. Sometimes they want to be a little more aggressive and say, ‘’hey, I want to buy all the way up to $80’’.

So now there are two positives as to why the stocks should go up. The first one is because earnings per share are getting better based on the equivalent multiple that you had form the previous quarter or year. Secondarily, you have now a big buyer; a huge amount of demand coming into the stock but the supply of stock is staying the same. There’s so catalyst now to sell the stock other than the prices now are going a little higher. So for short-term traders, this is amazing but, in 2010-2011, it wasn’t talked about enough that this was one of the major catalysts to the overall stock market.

Back then, you had real organic growth also but it was such a small portion of how much the stocks went up. The thing that nobody really talks about is, why is it bad for the future? So we all kind of understand why it’s good today and there’s actually a lot of people who have the strategy to just buy big buy back stocks because they think that they’re going to outperform the market since they have this big floor under them and also the earnings per share will go up higher than other companies. So there are companies out there that short stocks with smaller buy back without the capabilities of buy backs because they have bad balance sheets or too much bad ratings because of the debt on their sheets. They buy better quality companies that aren’t doing buy backs and the bigger without buy backs, the more they want owning.

There’s another strategy out there, which is more of an activist strategy; finding companies with good balance sheets that are not doing massive buy backs or massive dividends, and buying them in hopes that an activist will come into the company, buy a decent share and then, pressure the CEO to buy back the stock. So you have a lot of strategies based on the buy backs. Especially big head funds use this strategy.

Now the mainstream media’s been talking about it a little bit more; I wrote an article about it a little while ago actually. However, I still think that people are underestimating how important buy back are for the market and also, how important it is to keep an eye on interest rate because as they go up higher, it becomes more expensive to do these buy backs. This is kind of what we’re looking at right now. It’s an interesting concept because of interest rate going up, because they’re expecting future growth from pro-business government. You’re going to start seeing a little bit of the negatives coming in to the market. Another thing that nobody is talking about is that as interest rates go up, because they’re still moderately low, buy back are going to get more expensive to do and companies might think twice about it.

Now that’s all short-term and that’s one of the things that you should look at, especially if you’re investing in a company and you want to get more bang for your buck. You have to find the company that have monopolized the most amount of buy backs. I think almost every single company that’s S&P 500 has some type of buy back, even Apple, IBM etc. So, I would look to companies that have good balance sheets and have the ability to sustain the big buy backs. But, also, make sure that they’re focused on it. It’s much harder now to have organic growth when the GDP is around 1.5-2%. And, as interest rates go higher, it’ll be probably smarter to back out of companies that have gotten a lot of their growth from buy backs and maybe find companies that haven’t used buy backs as much and that are genuinely growing in this type of environment.

Moderator :
So Gary, where do you see the negatives long term?

Gary:
So the long term negative, I think, out-weight the short-term positives. In the beginning of the typical cycle, you have organic growth because the economy is expending after the recession. Companies are borrowing cash and using it to pay for positive things that are going to increase their competitiveness; updating capital structure, buying factories, buying robots, hiring people, research and development for companies who need it etc. Then, as you get closer to the end of this business cycle and companies are looking for growth in other places but can’t find it organically, they slow down the building, the capital infrastructure development investments etc, and look into Financial Engineering. Financial Engineering has typically only lasted the last 2-3 years of a bull market in a big sense. Obviously, there’s buy back all the time, but in a big sense where that’s the majority of how you grow your earnings, it’ll usually only last 1 or 2 years before you see some type of recession.

Now when you do see the recession, you typically need a good balance sheet to withstand it. The deeper the recession, the more on-hand cash you need, the better balance sheet you need. By doing these massive buy backs and destroying balance sheets, even at lower rates. It makes sense to do buy backs when rates are 1-2-3% and you can borrow at those types of rates long term. But, what ends up happening is that every company, when there’s a recession, needs to hold back on cash, on buy backs and also access pond markets and capital market to get cash so they don’t have to downsize as much as they probably should because they’re able to borrow the money, use that capital to stay afloat, withstand the recession, come out of it maybe even stronger and again, start growing from there as the economy re-bounce.

When you have such huge balance sheets, as some companies do now, I’m not quite sure how many will be able to withstand a higher interest rate environment, where investors don’t feel confident buying 30 year paper from IBM or whoever, at 2-3%. So what will happen is, these companies will have a much harder time raising capital at decent interest rate when their balance sheets are degraded so much. It’s kind of like what happened with Greece, but on a corporate level.

Moderator :
If I could make the analogy Gary, it’s sound almost QE on a corporate level. Would that be accurate? Sounds similar to something that China does with its stock market for instance, by just buying it.

Gary:
Yes, I think this happened because of QE. I think this is one of the things that QE wanted. The Federal Reserve’s idea was, if we make it cheap for companies to borrow money and not keep cash on their balance sheets, they’d borrow a ton on money. But, the second idea that never came across what that, once that they borrowed that money, they need to put that money somewhere because interest rates are low and they thought that they would put it back into their business; hire people, buy computers, build factories and all of this was supposed to spur investment in the US and the world, push up inflation, create jobs and make the recovery a lot smoother.

Now, the first part came true; they borrowed a ton of money but the second part never came true because the companies never believed in their recovery. So what they did is that they just bought back stock and the ones that didn’t borrow money got their arms twisted by activists. So, they were forced to buy back stocks anyway. So what ended up happening is that the money kind of burnt away. I’m not saying buy backs are back, but it’s not the most efficient way to get the money to the government. It’s a good way to get the money back to share holders, but unfortunately, only a small percentage of Americans or worldwide, own stocks. So they benefited from that. When you hold a stock in IRA, like most Americans do, they don’t sell it and use that cash because they can’t. So what happens is that they get appreciation in IRA, which they might use in 20 or 30 years, but it doesn’t matter today because, as the stock goes up today and crashes in 10 year, by the time you take out your IRA in 20 years, it’s at a different level anyway. So you’re not getting that benefit from that. So people who got benefit are people who own stock, but not in IRA. That’s a very small portion of Americans; typically called the top 1% although there are probably 10 to 20% of wealthy Americans who have significant holdings in stock. That goes down to the core of inequality because as assets went up, the people who own those assets, like real-estate in stocks, benefited much more than the ones who didn’t own assets or very few, which was the majority average middle class workers.

So, getting back to why it’s negative, it’s that you’ve degraded your balance sheet when there is going to be a recession or a pullback in economy; these companies are now going to be less able to take on debt and manage the recession.

The other problem is that, at some point, you’re to have to pay back the principle. So when interest rates are very low, that’s great, because you take it out and you pay a small interest rate of 1-2-3%, depending on the company when you took it out. But, typically, these companies are smart and they out long term paper (10-15 years) and at some point, you have to pay back that principle on the paper. When you pay it back, you have to pay it at current market rates. Right now, we are at a historically low interest rates. In 20-30 years, interest rate could be 8 to 10%. And, I hear talking about a huge burden of companies who have to refinance that paper from 3% to 6%. They’re now going to have to pay back double monthly what they paying now, if they able to even get it.

Moderator :
So not be too doomsday about it, but it seems like a dyer situation for corporate America; for all companies almost since all of them participate in these corporate buy backs. So what’s going to be the faith here? How are they going to deal with this?

Gary:
It’s a good question. I see this as a similar problem to the housing market. 8 to 10 years ago, it was slightly different; people were using their home equity and their houses to pay for the things such as cars and vacations. When the housing market crashed, they were basically holding a much more expansive house than what they bought it for because they re-financed and took money out of it. It was also worth a lot more than the current market rate so they just walked away from it.

Some of the benefits are that, if you borrow today and you have to pay back in 30 years, hopefully you’ll grow earnings enough to pay back the print symbol. The problem is that you’re actually stealing from the future. So as you pull forward all of the spending and borrowing and you’re not using it for spending. Then, nobody is buying your products as well. So IBM is doing massive buy back and that’s great, but they’re not buying other people’s products. Same way that when Apple does a buy back, instead of investing in buying Netflix or doing something else that people would think positive for their business, they’re buying back stock. They’re not taking away from other companies that would supply to Apple. So what you’re doing is that you’re stealing future growth rate by pulling it forward, which stocks will appreciate because de EPS goes up, but long term, it’s not great for anyone’s company because you’re not buying any products. So if IBM, instead of buying back stocks, would have borrowed money and wanted to get into another industry and hired tons of people, rented a space, bought more computer, software packages etc. So you’ve used a billion dollars and you’ve stimulated it. That billion dollars gets trickled down, split up, some of it goes down to the wages so people feel better, it also pushes up wages of other people because now there’s less people looking for jobs, those people spend money on computers and IBM products etc. So that’s kind of how capitalism should work. So IBM does that and helps out CISCO with routers and so on. Now CISCO needs to hire more people because IBM is doing that instead of putting money into buy backs.

That’s how the avalanche goes; it feeds off of each other. So when you use that money for buy backs, you can no longer borrow that money back. So as IBM’s balance sheet goes up and interest rate go up, it’s going to be much more difficult for them to borrow more money because people are going to say that they’ve borrowed a lot of money and have been making payments on this low interest payment but the sum is so big that it adds up and now, they want to borrow more money but interest rate are 5% instead or 3%. Currently on what they’re earning, that might just be too much. We either need to get paid a lot more for the risk or… It’s exactly what happened in Greece. After Greece joined the EU, its interest coupon rate dropped dramatically because it was seen as more trust worthy. Instead of continuing to borrow, let’s say, a hundred million dollars a year and cut their interest payment in half because the interest rate went down in half, they decided to just borrow more. They doubled the borrowing.

Moderator :
So Gary, I know you don’t have a crystal ball; nobody can tell what will happen in the future, but how do you think short term and long-term investors should tackle this problem?

Gary:
I think in the near term, you’re better off buying companies right now as this continues; although I think we’re getting towards the end of this buy back. I think you’ll continue to see that companies with bigger buy backs are going to do better. Now, for the short-term, that’s great for investment and if you’re able to move in and out of the stocks pretty quickly, I think, that’s a good idea to buy these companies with the buy backs. But, long-term, these companies will probably underperform other companies that have better balance sheets. So, if you need to buy a company, you need to kind of find a good medium; a company that is doing some sort of buy backs are going to help their earnings growth in the near term, but also, a company that is not degrading its balance sheet to a point where it’s going to have a difficult job competing with Chinese and European competitors who don’t do these types of trick, or do them on a smaller scale.

Saying that, there are a lot of companies that do have great growth rate or potential for growth rate. Amazon is exploding, it had a huge PE, but they’re not relying on buy backs. Tesla is not relying on buy backs. These companies have done really well. Facebook is not relying on buy backs. They’ve had real organic growth. The problem is that right now, organic growth is very expensive. So Amazon is trading at 80 times earnings, 80 PE. Facebook is high, but it’s getting cheaper because they’ve grown earnings so fast. Tesla doesn’t have earnings; it’s loosing money. These companies, based on historical ideas of what’s expensive, are expensive.

There’s a lot of places where to put your money. It’s just that you have to be cognisant of why earnings are going up and if you can find a company that has organic earnings growth, like Facebook, you’re going to get paid a lot more for it. The price of the stock will go higher and it’s better quality earnings. And, if you’re a long term holder, you have to also be cognizant, because if you’re holding stock for 20 years until you retire, you really want to be longest stock that short term is going to explode higher, but long term is probably not going to have the ability to compete when its does need to raise money; either to make a recession or maybe, just even compete from an aspect of upgrading its infrastructure and its research development and so on, because the Chinese and European are. It seems to me right now that American companies, due to this Financial Engineering, are kind of loosing their competitive edge a bit. So, if you’re long term minded, you got to take it down into account and see where is that earnings growth coming. Is it coming purely from buy backs? Is that their main strategy? And if it is, I’d be wary, maybe not now but in the nest 10 years, of companies doing tons of financial engineering to grow their stock price.

Moderator :
Gary, you said a lot of interesting things here today. Thank you so much for your time. We’ll stay tuned and as always, SizeTraders, subscribe and we’ll keep you updated. Until next time, this is Amos with Gary, head trader at SizeTraders.com. Gary, thanks again.

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